180. You said earlier that the relationship
with Equitable Life was not the way you liked to operate; and
you said you were encouraged that a number of insurance companies
were pursuing a closer relationship. I think many policyholders
will be worried by this approach, which seems to be based on building
up a friendly network. They will feel that the ones who potentially
are going to cause problems are the ones who do not have a close
relationship with you. Do you not feel that this kind of voluntary
approach is actually inadequate?
(Sir Howard Davies) I think it would be wrong to characterise
it as a "voluntary approach". The approach that we will
be taking in the future is a rigorously risk-based approach to
regulation. That is built on an assessment of what we perceive
to be the riskiness of this company to our objectives in other
words, principally the protection of the policyholders. The assessment
that we create of the riskiness of the companies is a combination
of the inherent riskiness of their business (and some insurance
companies and some banks are inherently in riskier areas of the
market than others) and the nature of the customers that they
have (and our bias is clearly to be more interested in companies
who have a relationship with a large number of policyholders,
rather than purely inter-professional business, if you like),
and also the strengths of the risk management systems within the
company and of its management. We have a clear architecture where
we assess that. A company that was operating in a way where we
did not feel that we were confident we were always getting a true
bill from the management, where we had a record of being surprised
by the management and not being told things, scores higher on
that element of the risk model and, therefore, attracts a higher
degree of attention. What you see in the Baird Report in the reference
to a note that was actually produced in 1999 about Equitable (in
fact the source of the phrase "arrogant superiority")
was, in fact, the first stage of thatwhere we were asking
our people to assess each company in the light of the risks it
posed to our objectives, and to include in that assessment a view
of the management and the kind of relationship that we have with
the management. Any company that is seeking not to be cooperative
scores more highly and attracts more of our attention.

Mr Fallon

181. We established two weeks ago, did we not,
that Equitable was the only company whose problems were subject
to the pre-handover note to the FSA back in 1998. You then told
us you pursued a rigorous approach to lack of reserves at Equitable.
What is the evidence of the additional scrutiny you subjected
Equitable to?
(Sir Howard Davies) Yes, it was true that it was the
only insurance company that was particularly drawn to our attention.
The insurance staff from the Treasury were, as you know, about
5 per cent of the organisation as it came together in early 1999.
Of course, there were a lot of other companies which were similarly
in our sights as companies that we had to look carefully at.

182. Compared to other life assurance companies,
what was the additional scrutiny?
(Sir Howard Davies) The attention paid within the
insurance division to Equitable Life was greater because it was
scoring more highly on our risk assessment than other companies
would have done. There were regular board reports about Equitable;
and regular reports to Michael Foot in particular.

183. When other life offices were making extra
reserves for guaranteed annuity options during the 1990s, why
was Equitable allowed to be an exception to the rule?
(Sir Howard Davies) Some companies did, as you say,
put in particular reserves within their portfolios. I could not
answer why Equitable was allowed to be an exception to it, because
I was not responsible for the regulation at the time.

184. You have told us that since 1998 you were
pursuing a rigorous approach?
(Sir Howard Davies) Indeed, that is what we were doing
precisely. We had identified, as a result of the Government Actuary's
survey which took place in the middle of 1998, Treasury regulators
had identified at that time that Equitable was in an unusual position.
It had an unusually large number of guarantees and it did not
have reserves in place to back those guarantees. They had identified
in the latter part of 1998 the need to put in place reserves;
and we pursued that and ensured that the company did put in place
reserves, and we overrode the threat that they would take us to
judicial review. That was the approach we pursued which I believe
was resolute at the time. As for why that had not been done earlierthat
goes back to the earlier period for which I cannot answer.

185. It was rigorous from the moment you took
over?
(Sir Howard Davies) I believe it was.

186. Let us look at the implicit future profits
item. Under the Contracting Out statutory instrument, the Treasury
retained responsibility for Section 68 Orders. However, the Minister
told us a fortnight ago that the Treasury were "wholly dependent"
on FSA advice. Were you aware of that?
(Sir Howard Davies) I was certainly aware of the fact
that the argumentation in relation to Section 68 waivers was put
to the Treasury by us; but I presumed that the Treasury looked
at the integrity of the argumentation we put forward and performed
some due diligence on that.

187. It would not be right that the Treasury
were wholly dependent on your views?
(Sir Howard Davies) They were wholly dependent on
our advice in the sense that we were the people who put forward
the propositions to them. If they were unhappy with them then
they could challenge them in the way that anyone with a proposition
they did not like the look of could do.

188. The responsibility for signing the Section
68 Orders rested with the Treasury, and not with the FSA?
(Sir Howard Davies) Yes, it did, and still does.

189. After the Lords' judgment in September
2000 the Insurance Supervisory Committee was then allowed to rejig
Equitable's balance sheet to the tune of £1.1 billion so
far as the implicit profits were concerned. Baird picks out that
this was done on the old resilience test and not on the new resilience
test, and it was done on Government Actuaries' advice and was
delivered before the Lords' judgment. Was that acceptable?
(Sir Howard Davies) I believe it was at the time.
(Mr Tiner) My understanding is that it was done on
the basis of the rules in place at that time. I was not here to
oversee that but that is my understanding.

190. Were you briefed on the operation of the
Insurance Supervisory Committee? Sir Howard, were you a member
of that committee?
(Sir Howard Davies) No.

191. Were you aware it was not even a proper
meeting, it was simply a telephone call?
(Sir Howard Davies) I was not aware of that until
the Baird Report was produced.

192. This was the only life insurance company
which was subject to a pre-handover warning notice that you claim
to have been rigorously regulating; and you were not aware that
it was allowed to rejig its balance sheet by £1.1 billion
by your own committee on the basis of a telephone meeting?
(Sir Howard Davies) I do not think I would necessarily
need to be aware of that if it was done consistently with the
rules. We have a system of delegation and delegated authority
which is necessary in an organisation which regulates 10,000 different
firms. I would also point out, once again in relation to this
idea of a handover note and a handover warning, the people who
were warning about Equitable Life were the people who were there.
It was not that there was a warning that was given by people who
did not come across. The briefing note that we received from the
team of insurance regulators was from the same people who came
across. There was no warning note delivered from anyone else in
the Treasury. Those people previously reported to senior management
in the Treasury and they came to us and they had within themselves
a view that Equitable Life was a company we ought particularly
to watch. This was not in any sense a communication from the Treasury
to the FSA. It was a communication within the regulatory system
by people who remained within the regulatory system. I had no
reason to think I had been warned by people outside my regulatory
department that there was a concern which they were not taking
seriously. They were the people who put up a warning and, therefore,
I had confidence that they acting in a way that was consistent
with that view of the company.

193. By 2000 I think a lot more people knew
what was going on. Baird reports to us that the chairman of the
Insurance Supervisory Committee simply sent an e-mail to the other
members stating: "Did not have time to put questions to individual
supervisors bilaterally". You are the Chief Executive of
this Authority, is that rigorous regulation?
(Sir Howard Davies) I do not attach a huge significance
to that. There is an enormous amount of business to transact within
the Authority. What I believe he was saying at the time was that
it was difficult to assemble a meeting with everybody, and what
was being done was consistent with the rules and, therefore, it
was acceptable it should be allowed to proceed.

194. On your major insurance worry the balance
sheet can be rejigged to the tune of £1.1 billion on the
basis of a telephone call from the chairman of one of your committees
and you are not even aware of it?
(Sir Howard Davies) The work was done based on actuarial
advice and an analysis of the position and representations from
the company. Yes, that kind of thing can happen and it can happen
all the time. As I say, in an organisation where we regulate 10,000
companies, I have to say, that will go on without the Chairman's
knowledge. It is quite unrealistic to think that all of those
decisions could be put up to the Chairman of the Board of the
Authority; that simply is not practical.

195. You are Chief Executive as well as the
Chairman?
(Sir Howard Davies) Indeed, and I would say exactly
the same thing.

Mr Nigel Beard

196. Sir Howard, in a memorandum from Mr Ned
Cazalet, which is Appendix 5 of our previous report on Equitable,
[1]he
says: "As a group, life offices began to make extra reserves
for guaranteed annuity options during the 1990s, tending to increase
reserving as gilt yields came down and longevity improved. Such
reserving was ad hoc and subject to a great deal of actuarial
discretion". Why, when other life assurance companies were
making provisions for potential GAR liabilities, was Equitable
Life allowed to be an exception to that rule?
(Sir Howard Davies) Once again, Mr Beard, I think
we are talking about a period before I took over responsibility
for the company. The story that we can tell from the Baird Report
was that, by early 1998, the supervisors were concerned about
the position of guaranteed annuities across the industry and,
therefore, decided to undertake a specific survey to ascertain
what the position was of a variety of different companies and
that led to the identification of Equitable Life. As to why that
identification was not made earlier, I am afraid I could not answer
that question.

197. Going to the Baird Report, paragraph 6.10.1,
page 212, he says: "During the Review Period, [that is January
1999 to December 2000] GAD was aware of the existence of entitlements
in GAO policies to pay additional premiums (or `top-up' the policies)
. . . However, the prudential regulator did not question the reserving
basis for these, despite information received from Equitable Life
in response to the GAD survey in 1998 that such entitlements were
available . . . neither IFSD [your own department monitoring this]
nor the GAD appear to have appreciated the significance of the
fact that the exposure could neither be reliably quantified nor
capped". Why did the FSA not appreciate that the findings
of the GAD survey indicated a potential black hole, because the
liability could not be capped?
(Sir Howard Davies) I cannot answer, Mr Beard, as
to why that did not happen. I simply have to accept the Baird
Review's view that that was not done, and the consequences which
flow from it in the following paragraph.

198. Was there any attempt made to make an assessment
of what the GAR liability might be?
(Sir Howard Davies) Yes, there was an attempt, because
that was the basis on which we were requiring the company to increase
its reserves in 1999. There was certainly an attempt to assess
what the liabilities would be. This is a particular dimension
of that, which is that the policies did have the possibility for
top-up in them. That, of course, is extremely difficult to assess,
because it depends on the individual tax position, and financial
position indeed, of the policyholder. It is not something you
can see from the face of the policy; because typically these policies
would allow you to make a contribution to the Inland Revenue rules
in relation to your income; and since you do not know what the
income level of the individual who owns the policy is, you cannot
be sure how much they would be entitled from an Inland Revenue
point of view to put into the policy. It was inherently very difficult
to assess; and that may have been part of the reason why no attempt
was made to assess it because we did not have (and indeed I do
not think Equitable Life would have) the information available
to make an accurate assessment; but clearly there was a liability,
albeit unquantifiable.

199. How important was this black hole liability
when Equitable Life was trying to find a buyer after the House
of Lords' judgment?
(Sir Howard Davies) It was undoubtedly a relevant
factor. When we talked to companies who were considering buying
Equitable Life, or indeed who had considered and rejected buying
Equitable Life, the unquantifiable nature of these was certainly
a factor. There were, however, other factors related to the fit
between the company, potential acquirer and the Equitable's business.
There was also considerable concern in the industry, which developed
during the course of 2000, that the future profitability of the
life industry would be lower than it had been in the past, influenced
by the 1 per cent cap on advice in relation to stakeholder pensions;
and that looking forward, given that a proportion of the market
would move into stakeholders with a 1 per cent cap, the overall
profitability of the kind of business mix that Equitable would
have had was going to be lower. That was a very important factor
certainly drawn to our attention. This was one factor, but I could
not say that it was a decisive factor in any of the negotiations
of which I am aware; but there were, of course, 15 or so companies
who began, and I could not tell you in relation to all of them
whether this was a decisive factor for them.